Introduction

Exchange-traded funds (ETFs) are very attractive investment vehicles, as outlined in a previous article entitled "Introduction to ETFs." However, there were 777 different ETFs as of the end of 2009, meaning that an investor can quickly become overwhelmed by trying to find the ETF that best suits his or her investment goals. This article outlines a strategy for selecting ETFs.

If you are a trader looking for ETFs mainly for short-term trading purposes, as opposed to long-term investment purposes, then Barchart.com provides a wealth of methods for finding ETFs with particular setups such as strong upside momentum, new highs/lows, gap up/down ETFs, and many other features. On the Barchart.com home page, just click on ETF menu item on the top menu bar and you will be taken to the ETF Overview page, which has various ETF lists on the left menu bar under the title of "Market Pulse." Barchart.com also offers an "ETF Screener" function that allows you to apply a group of filters to the universe of ETFs to find ETFs that exactly meet your specifications, including both fundamental and technical criteria.

If you are an investor looking for an ETF to hold as a longer-term investment in your portfolio, then you should follow these steps.

1. Choose an investment sector

First, consider the investment goals you are trying to meet with an ETF investment. Are you planning to use ETFs to build a core portfolio of stocks and bonds? Are you trying to diversify your portfolio beyond stocks and bonds and are therefore looking for other assets classes such as real estate, commodities, or hedge fund strategies? Or have you already covered your basic portfolio and you are now looking to take a flyer and invest a small portion of your portfolio in investment sectors with higher risk/reward potential?

After you have identified an investment sector, go to Barchart's ETF main page and click on the relevant Barchart.com/ETF investment sector to get a list of the ETFs in that sector. Also, check Barchart's article list to see if there is an article that discusses and makes recommendations for the sector in which you are interested.

2. Compare the ETF investment figures and component structures

From the list of ETFs in the investment sector, you should next winnow down the list by viewing the ETF information pages on Barchart.com, which will help you find the ETF that most closely matches your investment goals. Barchart.com provides a Profile page for each ETF with key information such as an ETF description, top 10 holdings, recent performance returns, dividend information, the management fee, the assets under management figure, and other key data. As an example of a Barchart.com/ETF profile page, click on the profile page for the SPDR S&P 500 ETF. You can also check with your brokerage firm as to whether an ETF can be margined, whether there are options on the ETF, and whether you can short-sell the ETF.

The information on Barchart.com/ETF can also help you investigate the component structure of an ETF, which is a critical factor for choosing an attractive ETF. ETF component structures can be very different even within narrow investment sectors, meaning an investor should thoroughly investigate how the ETF and the underlying index are constructed in terms of security selection and the weighting scheme.

Investors should obviously look for ETFs that hold attractive underlying component stocks that are likely to produce above-average returns over the long-run for the ETF fund as a whole. After all, an ETF in the end is simply the sum of its parts. Investors should also carefully consider the breakdowns of the ETF from the standpoint of geography, market cap, and stock sectors, to ensure that the ETF meets your investment goals and has strong potential for long-term appreciation.

3. Consider the ETF's component weighting system

The weighting system used by the ETF for its component holdings is often much more important than many investors may think. An investor that is new to the ETF sector might think that all ETFs are simply weighted by a simple market capitalization scheme like the S&P 500. However, ETFs use a wide variety of weighting schemes. The question for an investor is whether the weighting scheme for a particular ETF is appropriate and is likely to lead to attractive returns in the long run.

Most ETFs follow a basic "market capitalization" weighting scheme. This scheme simply assigns weights to each stock in proportion to its market cap size, meaning that large-cap stocks will have a high percentage weight in the fund and small-cap stocks will have a small percentage weight. However, in the ETF industry, the raw market cap weighting scheme sometimes needs to be modified so the ETF can meet the diversification requirements of the tax laws and the Registered Investment Company (RIC) rules. For example, the RIC diversification rules state in part that no single security in an ETF can have a weight greater than 25% and that stocks with a weight over 5% cannot together equal more than 50% of the fund. RIC requirements can have a big impact on the design of an index weighting scheme when the number of stocks in an index is below about 50. When there are fewer than 50 stocks in an ETF, most indexes will have secondary rules that adjust the weighting scheme to make sure the index meets the RIC diversification requirements.

A market-cap weighting scheme is appropriate for an index that is tracking the broad stock market or a particular stock sector such as energy or materials. However, an equal-weighted index can be more appropriate when the purpose of the index is to track an investment theme, such as water, that cuts across traditional SIC or GICS industry codes. A theme-based ETF generally wants to give more equal weights to large and small cap stocks, avoiding the situation where a few large-cap stocks dominate the weighting and performance of the ETF. An equal-weighted index gives small-cap stocks a larger influence on the overall ETF performance.

As an example of an equal-weighted ETF, the PowerShares Global Water Portfolio (PIO) tracks the Palisades Global Water Index (PIIWI), which is a modified equal-weight index. The Palisades water index first assigns a portfolio weight to each of six different water sub-sectors: utilities, treatment, infrastructure, analytical, resource management, and multi-business. Within those sub-sectors, each stock is then given an equal weight. This weighting scheme attempts to assign weights to each stock depending on its importance in the overall water sector, as opposed to sticking to a rigid market-cap weighting scheme. This has the effect of boosting the weight of smaller-cap, pure-play stocks that may be more closely tied to the investment theme and produce higher returns than the larger diversified companies with a multitude of different business divisions. Most theme-based indexes include only "pure play" stocks in their component list, i.e., companies that derive more than 50% of their revenue from the investment theme.

4. Consider the historical returns of the ETF

The historical performance of an ETF is of course interesting to look at but as the saying goes, "past performance is not necessary indicative of future results." An ETF that has performed well in the past will not necessarily perform well in the future. We like the idea of focusing on an ETF's investment case and its component structure rather than relying simply on backward looking historical performance. Nevertheless, historical performance is still a factor to consider in choosing between otherwise similar ETFs. In order to look at historical performance, investors can simply match up the returns for ETFs shown in each ETF's Barchart.com profile.

In order to create these types of comparison charts yourself, simply bring up the first chart as usual with the Barchart.com technical chart menu, and then enter the ticker symbol for the second chart in the "Compare to" field. You can add up to three "Compare to" symbols, meaning you can display up to four ETFs on a single chart. Just click the check box next to the "% Change" field in order to overlay the charts on a common percentage index scale. You can also change the data frequency to "Weekly Chart" and "Monthly Chart" in order to look at the ETF comparisons on a longer-term basis.

5. Compare expense fees

The expense fee for an ETF is obviously an important factor to consider in choosing an ETF. ETF issuers/managers charge the fund an expense fee in return for managing the portfolio. Finding an ETF with a low expense fee is particularly important when you are choosing a competitive core portfolio ETF such as an S&P 500 ETF. When ETFs in a particular investment sector are virtually identical, then it only makes sense to choose the one with the lowest expense.

On the other hand, if you are looking at ETFs in unique investment areas such as commodities or stock sectors, then we believe you should be less focused on fees and more focused on whether that ETF will perform better than the other ETFs in the sector. In a sector where you are aiming for a high risk/reward ratio, it doesn't make sense to bypass an attractive ETF just because its fee is 5 or 10 basis points higher than an inferior ETF. In theory, the potential return that could be earned from the attractive ETF should dwarf the higher expense fee.

Several large brokerage firms now offer commission-free trading on in-house ETFs. If you are a customer of a brokerage firm that has in-house ETFs, and those ETFs are virtually identical to ETFs offered by other ETF issuers, then it makes sense to buy the in-house ETF and save the commission expense, particularly if you are engaged in active ETF trading.

6. Consider ETF issuer size and quality

Not all ETF issuers and ETFs are created equal. There is clearly a big difference between the ETF behemoths in the industry such as iShares and a newcomer to the ETF industry that may not survive. The ETF industry is a highly competitive business with low fees and low profit margins, making it difficult for small firms to survive. The larger ETF issuers have large capital bases and enjoy economies of scale on costs, thus providing investors with more assurance about their long-term financial health. Our advice is to stick with the larger ETF issuers unless a smaller ETF issuer has a particularly unique ETF not offered by the big issuers.

One of the advantages of an ETF is that it is a stand-alone legal entity and is only managed by its ETF issuer/manager. If an ETF issuer/manager goes bankrupt, then in theory the funds in the ETF should be left intact because the securities and cash owned by the ETF are in a segregated account. If an ETF issuer/manager goes bankrupt, then the ETF could switch managers or in the worst case the fund will be liquidated and the fund's segregated funds will be returned to shareholders. However, the funds could be tied up in the fund for weeks or months while the legal process plays out, meaning investors should generally play it safe and stick to large and well-capitalized ETF issuers.

7. Consider the ETF's liquidity and "assets under management" size

When choosing an ETF it is very important to consider the amount of "assets under management." This figure is available in the Barchart.com/ETF Profile section for each ETF. Generally speaking, the first ETF launched in a particular investment sector often has such a large first-mover advantage that it retains a dominant position indefinitely with the largest amount of assets under management. Other ETF issuers will often try to launch similar ETFs in that investment sector, but very seldom will a second or third ETF beat the first ETF in the sector, even if the second or third ETF has some more attractive features. From a liquidity and safety standpoint, it is often better to select the largest ETF in a sector if its attributes are at least as attractive as the smaller ETFs in that sector.

An ETF that has trouble attracting assets is at risk of eventually being shut down by the ETF issuer and having its capital returned to shareholders. ETF issuers periodically do a house cleaning and shut down ETFs that have low assets under management and seem to have little hope of gaining traction. The profitability breakeven points for individual ETFs vary widely in the ETF business, depending on the ETF itself and on the size of the ETF issuer. However, we would caution against buying any ETF that has less than $10 million of assets under management, unless it is a brand new ETF and seems to be gaining traction. We would avoid buying an ETF with assets under management of between $10 million and $50 million, unless it is a unique ETF without a larger competitor.

Aside from viability issues, smaller ETFs usually have fewer market makers, slightly wider bid-offer spreads, and potentially higher deviations between the ETF price in the marketplace and its net asset value (NAV). This is another reason to avoid very small ETFs unless there is a particularly good investment case for that ETF.

The bottom line

The bottom line is that it can be overwhelming to find the best ETF. However, Barchart.com/ETF has the wealth of tools and information that you need to find attractive ETFs.

From the Barchart.com ETF Research Team
Last Updated: August 17, 2010
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